Unlevered BTIRR problem The property is a specialty retail property (which is in

Question

Unlevered BTIRR problem

The property is a specialty retail property (which is interesting, but not relevant to the solution). Mr. Beyer is planning to acquire the property, hold it for five years and then sell it at the end of the fifth year.

* The first year net operating income (NOI) is projected to be $8,460,750. Mr. Beyer is projecting that, based on increasing base rents and increasing percentage rents, his NOI will increase at a compounded annual rate of 4%.

* His closing costs (legal, recording, appraisal, environmental, engineering, title, etc.) will come to $600,000. These closing costs will be expended simultaneous to taking title.

* In the fifth year of the holding period, in order to prepare the property for disposition, Mr. Beyer intends to spend $3,500,000 in property upgrade, and he builds in that assumption to his numbers. This capital expenditure is, of course, an increase in his equity investment.

* Mr. Beyer projects his sale to the next purchaser at the end of the fifth year. The sales price will be determined by utilizing a residual or terminal capitalization rate of 9.15% of the projected sixth year NOI (rounded to the nearest $100,000). After all, the next buyer is buying future income, not past income. But Mr. Beyer also projects a cost of sale (legal, marketing, brokerage) of an amount equal to 2% of the gross sales price. This cost of sale will be deducted from his gross sale price to arrive at net sales proceeds.

If all of Mr. Beyer’s projections are accurate, and if he pays $92,000,000 for this property, what will be his before tax IRR (BTIRR)?

ANSWER FOR PART 1

PART 2

ATIRR Unlevered: Income taxes are taken into account in the calculation of IRR.

This is a continuation Part I. The additional information is:

* 75% of Mr. Beyer’s purchase price of $92,000,000 is attributable to the improvements (the building) and will be depreciated on a 39-year straight-line basis. As you know, depreciation is a deduction for purposes of calculating taxable income. (The 25% portion of the price attributable to land is, of course, not depreciable.)

* The front-end closing costs of $600,000 are capitalized and amortized evenly over his anticipated five-year holding period. Closing costs are a deductable item.

* The income tax (the tax on each year’s taxable income from operations) rate is 36%.

* Gains Tax: His capital gain (the net sales proceeds in excess of his depreciated basis) is segmented into (a) the net sales proceeds in excess of his purchase price, which is taxed at a rate of 15%, and (b) the amount of depreciation he has taken during his ownership, which is taxed at a rate of 20%.

The $3,500,000 capital expenditure in the fifth year will not be depreciated by Mr. Beyer since it is made during the same period as his disposition of the property.

What is Mr. Beyer’s after-tax IRR (ATIRR)?

SHOW IN EXCEL

ANSWER FOR PART 2:

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Part III

Levered ATIRR

The facts are the same as before. But now Mr. Beyer is going to finance the acquisition, because after seeing the projected impact of income taxes on his BTIRR (his 12.20% IRR became 8.867%), he has decided to add debt leverage. He obtains a loan from the Actuarially Correct Life Insurance Company. The loan is funded at the time the property is acquired.

The terms and conditions of the constant pay mortgage (CPM) loan are:

Annual rate of 7%; monthly payments; 25-year amortization schedule.

The loan amount is not given here. You must calculate the loan amount based on the following: The loan’s first year’s debt service coverage ratio (DSCR), which is the ratio of the NOI to the loan constant, is 1.3855145x. (Round the loan amount to the nearest $100 for this exercise.)

The lender charges an upfront “commitment fee” of 1% of the loan amount. This fee is paid at the time of loan closing, is capitalized, and is amortized evenly by Mr. Beyer over the anticipated five year holding period.

The loan contains a “due on sale” clause: The loan must be repaid when Mr. Beyer sells the property.

The loan has a prepayment penalty of 1½% of the loan balance at the time of prepayment. The prepayment penalty is treated as interest in the year in which it is paid, and so it is deductible for purposes of calculating income tax in that year.

Your assignment:

What’s Mr. Beyer’s levered ATIRR, that is, what’s the ATIRR to Mr. Beyer’s equity taking into account the effect of the financing? Before adding debt, Mr. Beyer’s equity was 100% of the purchase price. Now it is the difference between the purchase price and the loan amount that you have calculated.

What is the impact of adding debt to the IRR? In other words, what is the increase or decrease to the equity IRR; by how many basis points did the mortgage financing increase or decrease Mr. Beyer’s ATIRR?

Now, directing your attention to the lender, what’s the lender’s BTIRR? (It’s not 7%.)

Be careful! Interest is deductible; amortization is not.

Explanation / Answer

Loan Amount: DSCR= NOI/loan 1.3855145=8460750/loan Loan= 8460750/1.3855145 Loan 6106600 Commitment fee 61066 Commitment fee P.A. 12213 Year Principal Interest Total Payment Balance (A) (B) (A + B) 1 15121 71200 86320 6091479 2 94513 423409 517922 5996967 3 101345 416577 517922 5895622 4 108671 409251 517922 5786950 5 116527 401395 517922 5670423 early repayment -5670423 repayment charges1.5% 85056.34 Year 0 1 2 3 4 5 Purchase price -92000000 closing costs -600000 EBIT 6571519 6909949 7261916 7627962 8008650 Interest -71200 -423409 -416577 -409251 -401395 prepayment interest -85056.345 PBT 6500319 6486540 6845339 7218711 7522198.655 income tax @ 36% -2340114.84 -2335154.4 -2464322.04 -2598735.96 -2707991.516 Profit After Tax 4160204.16 4151385.6 4381016.96 4619975.04 4814207.139 Amortized cost 120000 120000 120000 120000 120000 Annual Depreciation 1769231 1769231 1769231 1769231 1769231 Capex -3500000 net sales proceeds 11250000 Gains tax on appreciation -2212500 Gains tax on acc depreciation -1769231 cashflow -92600000 6049435.16 6040616.6 6270247.96 6509206.04 10471707.14 ATIRR 7.7832%

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